Doug Noland: Mania

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This might be the most fascinating market backdrop of my career. Not yet as dramatic as 1987, 1990, 1994, 1997, 1998, 1999, 2000, 2002, 2007, 2008, 2009 or 2012 – but, heck, we’re only two weeks into 2018 trading.

In the first nine trading sessions of the year, the DJIA tacked on almost 500 points. The S&P500 has advanced 4.2%, the Dow Transports 7.2%, the KBW Bank Index 6.0%, the Nasdaq100 5.7%, the Nasdaq Industrials 5.7%, the Nasdaq Bank Index 5.7%, the Nasdaq Composite 5.2%, the New York Arca Oil index 7.1%, the Philadelphia Oil Service Sector Index 9.8%, the Semiconductors (SOX) 5.5%, and the Biotechs (BTK) 6.3%.

It’s synchronized global speculation unlike anything I’ve witnessed. Italian stocks are up 7.2%, French 3.9%, Spanish 4.2%, German 2.5%, Portuguese 4.0%, Belgium 4.7%, Austrian 5.2%, Greek 6.1% and Icelandic 4.1%, European Bank stocks (STOXX600) have gained 5.4%, with Italian banks up double-digits. Hong Kong financials have gained 5.9%. Japan’s Topix Bank index is up 5.6%. Japan’s Nikkei has gained 3.9%, Hong Kong’s Hang Seng 5.0%, and China’s CSI 300 4.8%. Stocks are up 7.2% in Russia, 6.7% in Romania, 4.8% in Bulgaria and 5.8% in Ukraine. In Latin America, major equities indexes are up 3.9% in Brazil, 3.0% in Chile, 4.0% in Peru and 8.8% in Argentina.

It’s evolved into a full-fledged speculative Bubble and intense Mania. This type of euphoria, while fun and captivating, comes with unfortunate consequences. But there will be no worry for now. None of that. Once things have regressed to this point, negative news and troubling developments are easily disregarded. Speculation detached from reality.

I recall the speculative market that culminated in manic trading in the summer of 1998 – just weeks before the global system convulsed with the collapses of Russia and Long-Term Capital Management. There was the first quarter 2000 technology stock speculative melt-up – right in the face of deteriorating industry fundamentals. And how can we forget the fateful “subprime doesn’t matter” speculative run to all-time highs in the Autumn of 2007.

The backdrop is extraordinarily fascinating because of the intensity of speculative excess in the face of key developments that hold the potential to bring this party to a conclusion. Headlines from the week: “China Weighs Slowing or Halting Purchases of U.S. Treasuries.” “ECB Hawks Take the Lead on QE Debate as Doves Stay Quiet.” “Japan’s Central Bank Trims Bond Purchases, Prompting Taper Talk.” “Yen’s Spike Shows Taste of What Comes When BOJ Really Does Shift.” “ECB Joins Central Bank Chorus Hinting at Faster Tightening.” “Fed’s Dudley Warns That Tax Cuts Putting Economy on an ‘Unsustainable Path’.” “U.S. Core Consumer Prices Post Biggest Gain in 11 months.” “Investors Spooked at Specter of Central Banks Halting Bond-Buying Spree.”

Not all that spooked. “Junk-Bond Funds See Largest Cash Inflows Since December 2016.” Investment-grade funds saw inflows of $4.186bn. And while 10-year Treasury yields were up 7 bps this week – and 14 bps to begin 2018 – there’s certainly no panic. Even the so-called bonds bears forecast the mildest of bear markets. I haven’t seen any predictions of a big backup in yields. A 1994 tightening cycle – 10-year Treasury yields up 250 bps – is today unimaginable. Yet excesses during ‘91-93 barely register when compared to the last nine years.

A Bloomberg News article, based on unnamed “senior government officials,” reported that China was considering slowing or halting purchases of U.S. Treasury securities. Though denied by Chinese authorities, this news resonated in the marketplace. The Bloomberg report followed by two days a Politico article, “White House Preparing for Trade Crackdown.”

It’s worth an additional look at pertinent Q3 Z.1 “flow of funds” analysis: “Rest of World holdings of U.S. Financial Assets jumped $724 billion (nominal) during the quarter to a record $26.347 TN. This puts growth over the most recent three quarters at a staggering $2.124 TN (16% annualized). What part of these flows has been associated with ongoing rapid expansion of global central bank Credit? It’s worth recalling that ROW holdings ended 2007 at $14.705 TN and 1999 at $5.639 TN. As a percentage of GDP, ROW holdings of U.S. Financial Assets ended 1999 at 57%, 2007 at 100%, and Q3 2017 at a record 135%.”

In a world awash in finance, and foreign “money” has been pouring into U.S. securities markets. China has been a major purchaser of Treasuries, as it recycles a massive and growing trade surplus with the U.S. (around $300bn in ’17). And as financial flows inundated EM in 2017, emerging central banks also turned significant buyers of U.S. government debt. At an estimated $2.7 TN, global QE played a major role in global liquidity abundance, “money” that at least partially circulated into booming U.S. securities markets.

There is a prevailing view in the U.S. that QE doesn’t matter. The Fed ended balance sheet expansion a few years back, and financial markets didn’t miss a beat. Better yet, the Fed is now contracting its balance sheet holdings and stock market gains have only accelerated. The reality is that it’s a global Bubble fueled by globalized liquidity. Central bank QE liquidity is fungible – $14 TN and counting.

Ten-year Treasury yields jumped to 2.60% on Wednesday’s China story, although they drifted back down on Chinese denials. And while the attention was on market yields, the more fascinating moves were in the currencies. The euro gained 1.4% this week on the rising prospect of an early end to the ECB’s QE program.

January 7 – Reuters (Sam Edwards): “The European Central Bank should set a date to end its asset-buying program, the head of Germany’s Bundesbank, Jens Weidmann, told Spanish newspaper El Mundo. Tipped as a potential candidate to succeed ECB President Mario Draghi when his term expires at the end of October 2019, Weidmann is a vocal critic of the bank’s quantitative easing program. ‘The prospects for the evolution of prices correspond to a return of inflation to a level sufficient to maintain the stability of prices. For this reason, in my opinion, it would be justifiable to put a clear end to the buying of debt bonds by establishing a concrete date (for ending the program),’ Weidmann said…”

The euro’s gain this week was overshadowed by the 1.8% surge in the Japanese yen.

January 8 – Bloomberg (Chris Anstey): “A minor tweak in a regular Bank of Japan bond-purchase operation on Tuesday was enough to send the yen climbing the most in almost a month, even though evidence weighs overwhelmingly against the adjustment signifying anything meaningful. What the yen’s spike does show is just how big a move will come whenever the central bank does telegraph a fine-tuning in its stimulus program. Tuesday’s gain was as big as 0.5% against the dollar, in wake of the BOJ trimming purchases of bonds dated in 10-to-25 years by 10 billion yen ($89 million) compared with its previous operation.”

By their nature, speculative Bubbles and melt-ups are at heightened risk to unexpected developments. The current environment is so fascinating specifically because there are anticipated developments capable of bringing this long party to an end. The Trump administration appears determined to focus on trade in 2018, with China in the crosshairs. China has more than ample Treasury holdings to sell if it decides to make a point.

Meanwhile, it’s no coincidence that with global markets going nuts we are beginning to hear more decisive hawkish talk from around the world of central banking. Bundesbank president Jens Weidmann’s preference for a “clear end” to bond purchases should not be dismissed. The likelihood that ECB purchases end completely in October are rising. Moreover, I would expect growing momentum within the executive board for ending the open-ended nature of Draghi’s stimulus doctrine. Mr. Weidmann is a leading candidate to head the ECB next year at the completion of Draghi’s term. Even if a German is not soon at the helm of the European Central Bank, expect a push to return to traditional monetary management. I’m not anticipating an immediate return to “the ECB does not pre-commit.” But perhaps it’s time for the markets to become less complacent with regard to assurances of open-ended market support and permanently very low rates.

Prospects are growing for a 2018 tightening of global financial conditions. But with stocks rising percentage points by the week, there’s great incentive to focus on the here and now of over-liquefied market conditions. Besides, won’t the potential for a destabilizing spike in the yen keep Kuroda on full throttle? Don’t the doves still hold the majority at the ECB? Won’t the risk of a looming trade war with China (and others) ensure the Fed remains cautious, placing a lid on Treasury yields? Besides, the Chinese are too smart for the type of wound to be self-inflicted from threatening to dump Treasuries – aren’t they?

Markets are sure willing to assume a lot and ignore even more. There remains overwhelming confidence that global central bankers will work in concert to ensure markets don’t buckle, at least so long as inflation stays well-contained. Rising inflationary pressures are one of my Themes 2018. WTI crude traded to $64.30, up 6.4% in two weeks to a near three-year high. The GSCI Commodities Index rose 2.1% this week. The dollar index has declined 1.2% to begin the new year.  Interestingly, Gold is up a quick 2.7%.

General inflationary pressures have gained some momentum. The global economy has attained strong momentum. And markets these days are left to contemplate how a runaway global risk market melt-up could impact economic activity and what an outright boom might mean to inflation dynamics.

German 10-year bund yields jumped 15 bps this week to a near two-year high 58 bps. Yields rose 11 bps in Switzerland, and 10 bps in Sweden, the UK, and Australia. Mexico yields surged 22 bps, Russia 27 bps and Brazil eight bps. There’s the old market adage that you know you’re commencing a bear market when prices decline yet people are feeling pretty good about it.

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